<PAGE>

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q

(Mark One)
[X]       QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
               EXCHANGE ACT OF 1934

 For the Quarterly period ended  December 31, 2002
                                 -----------------

                                       OR

[  ]      TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
               EXCHANGE ACT OF 1934

Commission File Number  1-14007
                        -------

                               SONIC FOUNDRY, INC.
                               -------------------
             (Exact name of registrant as specified in its charter)

                MARYLAND                               39-1783372
     -------------------------------               ------------------
     (State or other jurisdiction of                (I.R.S. Employer
     incorporation or organization)                Identification No.)

                     1617 Sherman Avenue, Madison, WI 53704
                     --------------------------------------
                    (Address of principal executive offices)

                                  (608)256-3133
                                  -------------
                             (Registrant's telephone
                           number including area code)

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days
Yes    X          No
    ------           ------

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes               No    X
    ------           ------

State the number of shares outstanding of each of the issuer's common equity as
of the last practicable date:

                                                       Outstanding
                  Class                               Feb 13, 2002
                  -----                               ------------
      Common Stock, $0.01 par value                    27,784,509

<PAGE>

                                TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                        PAGE NO.
                                                                        -------
<S>                                                                     <C>
PART I    FINANCIAL INFORMATION

Item 1.   Consolidated Financial Statements

          Consolidated Balance Sheets - December 31, 2002 (Unaudited)
            and September 30, 2002 ......................................  3

          Consolidated Statements of Operations (Unaudited) -
            Three months ended December 31, 2002 and 2001 ...............  5

          Consolidated Statements of Cash Flows (Unaudited) -
            Three months ended December 31, 2002 and 2001 ...............  6

          Notes to Consolidated Financial Statements (Unaudited) ........  8

Item 2.   Management's Discussion and Analysis of Financial
            Condition and Results of Operations ......................... 14

Item 3.   Quantitative and Qualitative Disclosures
            About Market Risk ........................................... 21

Item 4.   Controls and Procedures ....................................... 21

PART II   OTHER INFORMATION

Item 3.   Defaults under Senior Securities .............................. 22

Item 6.   Exhibits and Reports on Form 8-K .............................. 22
</TABLE>

                                        2

<PAGE>

                               Sonic Foundry, Inc.
                           Consolidated Balance Sheets
                        (in 000's except for share data)

<TABLE>
<CAPTION>
                                                             December 31,  September 30,
                                                                2002           2002
                                                                ----           ----
                                                             (unaudited)
<S>                                                            <C>         <C>
Assets
Current Assets:
   Cash and cash equivalents                                   $ 2,305     $ 3,704
   Accounts receivable, net of allowances of $640 and $729       3,950       3,886
   Accounts receivable, other                                       71          89
   Inventories                                                     424         362
   Prepaid expenses and other current assets                       495         619
                                                               -------     -------
      Total current assets                                       7,245       8,660

Property and equipment:
   Buildings and improvements                                    2,450       2,450
   Equipment                                                    13,311      13,263
   Furniture and fixtures                                          568         567
                                                               -------     -------
     Total property and equipment                               16,329      16,280
     Less accumulated depreciation                               8,438       7,584
                                                               -------     -------
        Net property and equipment                               7,891       8,696

Other assets:
   Goodwill and other intangibles, net                           8,242       8,255
   Capitalized software development costs, net                   1,233       1,333
   Debt issuance costs, net of $445 and $323 of amortization       531         653
   Other assets                                                     42          46
                                                               -------     -------
     Total other assets                                         10,048      10,287
                                                               -------     -------
Total assets                                                   $25,184     $27,643
                                                               =======     =======
</TABLE>

See accompanying notes

                                       3

<PAGE>

                               Sonic Foundry, Inc.
                           Consolidated Balance Sheets
                        (in 000's except for share data)

<TABLE>
<CAPTION>
                                                                                       December 31,     September 30,
                                                                                          2002              2002
                                                                                          ----              ----
<S>                                                                                   <C>              <C>
Liabilities and stockholders' equity                                                    (unaudited)
Current liabilities:
   Accounts payable                                                                      $  2,518         $  3,035
   Unearned revenue                                                                            87               62
   Accrued liabilities                                                                      1,350            1,090
   Accrued restructuring charges                                                                7               93
   Current portion of long-term debt                                                        1,489              574
   Convertible debt, net of discount                                                        3,936            3,482
   Current portion of capital lease obligations                                               608              820
                                                                                         --------         --------
   Total current liabilities                                                                9,995            9,156

   Long-term obligations, net of current portion                                              350              323
   Capital lease obligations, net of current portion                                           28               64
   Other liabilities                                                                          120              116

Stockholders' equity:
   Preferred stock, $.01 par value, authorized 5,000,000
      shares; none issued and outstanding                                                      --               --
   5% preferred stock, Series B, voting, cumulative,
      convertible, $.01 par value (liquidation preference at
      par), authorized 10,000,000 shares, none issued and
      outstanding                                                                              --               --
   Common stock, $.01 par value, authorized 100,000,000
      shares; 27,812,259 and 27,729,825 issued and 27,784,509 and 27,702,075
      outstanding at December 31, 2002 and September 30, 2002                                 278              277
   Additional paid-in capital                                                             167,055          167,028
   Accumulated deficit                                                                   (152,332)        (148,985)
   Receivable for common stock issued                                                         (26)             (26)
   Cumulative foreign currency translations                                                  (100)            (111)
   Unearned compensation                                                                      (34)             (49)
   Treasury stock, at cost, 27,750 shares                                                    (150)            (150)
                                                                                         --------         --------
   Total stockholders' equity                                                              14,691           17,984
                                                                                         --------         --------
Total liabilities and stockholders' equity                                               $ 25,184         $ 27,643
                                                                                         ========         ========
</TABLE>

See accompanying notes

                                       4

<PAGE>

                               Sonic Foundry, Inc
                            Statements of Operations
                                   (Unaudited)
<TABLE>
<CAPTION>
                                                                              Three months ended
(in 000's except for per share data)                                              December 31,
                                                                              2002             2001
                                                                              ----             ----
<S>                                                                       <C>              <C>
Revenue:
Software license fees                                                      $   4,121         $   3,691
Media services                                                                 1,911             2,347
                                                                           ---------         ---------
    Total revenue                                                              6,032             6,038
Cost of revenue:
Cost of software license fees                                                    831               999
Cost of media services                                                         1,651             1,777
                                                                           ---------         ---------
    Total cost of revenue                                                      2,482             2,776
                                                                           ---------         ---------

Gross margin                                                                   3,550             3,262

Operating expenses:
Selling and marketing expenses                                                 2,371             2,401
General and administrative expenses                                            1,701             1,601
Product development expenses                                                   1,561             1,847
                                                                           ---------         ---------
    Total operating expense                                                    5,633             5,849
                                                                           ---------         ---------
Loss from operations                                                          (2,083)           (2,587)

Other income (expense):
Interest expense                                                                (267)              (35)
Non-cash interest expense                                                     (1,085)               --
Interest and other income                                                         (1)                4
                                                                           ----------        ---------
    Total other income (expense)                                              (1,353)              (31)
                                                                           ---------         ---------
Loss before income taxes and cumulative effect of change in
  accounting principle                                                        (3,436)           (2,618)
Income tax benefit                                                                89                --
                                                                           ---------         ---------
Loss before cumulative effect of change in accounting principle               (3,347)           (2,618)
Cumulative effect of change in accounting principle                               --           (44,732)
                                                                           ---------         ---------
Net loss                                                                   $  (3,347)        $ (47,350)
                                                                           =========         =========

Loss per common share:
Loss before cumulative effect of change in accounting principle            $   (0.12)        $   (0.10)
Cumulative effect of change in accounting principle                               --             (1.74)
                                                                           ---------         ---------
Net loss per common share -basic and diluted                               $   (0.12)        $   (1.84)
                                                                           =========         =========
</TABLE>

See accompanying notes

                                       5

<PAGE>

                               Sonic Foundry, Inc.
                      Consolidated Statements of Cash Flows
                                   (Unaudited)

<TABLE>
<CAPTION>
                                                                                         Three months ended
                                                                                             December 31,
(in 000's)                                                                             2002                 2001
                                                                                  --------------------------------
<S>                                                                             <C>                   <C>
Operating activities
Net loss                                                                          $    (3,347)        $    (47,350)
Adjustments to reconcile net loss to net cash used in operating activities:
   Cumulative effect of change in accounting principle                                      -               44,732
   Amortization of capitalized software development costs                                 113                   55
   Depreciation and amortization of property and equipment                                857                  862
   Amortization of debt discount and debt issue costs                                   1,085                    -
   Noncash charge for common stock warrants and options                                    14                  143
   Loss on sale of assets                                                                   -                    4
   Changes in operating assets and liabilities:
     Accounts receivable                                                                  (56)                (254)
     Inventories                                                                          (62)                 215
     Prepaid expenses and other assets                                                    128                  394
     Accounts payable and accrued liabilities                                            (305)                (637)
                                                                                  -----------         ------------
Total adjustments                                                                       1,774               45,514
                                                                                  -----------         ------------
Net cash used in operating activities                                                  (1,573)              (1,836)
                                                                                  -----------         ------------

Investing activities
Acquisition, net of cash acquired                                                           -                 (435)
Purchases of property and equipment                                                       (18)                (171)
                                                                                  -----------         ------------
Net cash used in investing activities                                                     (18)                (606)

Financing activities
Proceeds from sale of common stock                                                         38                  152
Proceeds from debt, net                                                                 1,069                    -
Payments on long-term debt and capital leases                                            (838)                (384)
Payments on line of credit, net                                                           (87)                   -
Cash placed in escrow                                                                       -               (1,000)
                                                                                  -----------         ------------
Net cash provided by (used in) financing activities                                       182               (1,232)
Effect of exchange rate changes on cash                                                    10                  (11)
                                                                                  -----------         ------------
Net decrease in cash                                                                   (1,399)              (3,685)
Cash and cash equivalents at beginning of period                                        3,704                7,809
                                                                                  -----------         ------------

Cash and cash equivalents at end of period                                        $     2,305         $      4,124
                                                                                  ===========         ============
</TABLE>

                                       6

<PAGE>

                               Sonic Foundry, Inc.
                Consolidated Statements of Cash Flows (continued)
                                   (Unaudited)

Supplemental cash flow information:
   Interest paid                                                $ (191)  $  (35)
   Income taxes refunded                                           180        -
Non-cash transactions -
     Capital lease acquisitions                                     30       16
     Issuance of options for deferred compensation plan              -      104
     Issuance of warrants for consulting services                    -       49
     Conversion of exchangeable stock into common stock              -      475
     Issuance of common stock and stock options for MediaSite        -    5,016

     See accompanying notes

                                       7

<PAGE>

1.    Basis of Presentation and Significant Accounting Policies

Interim Financial Data

The accompanying financial statements have been prepared in accordance with
accounting principles generally accepted in the United States for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X.

Accordingly, they do not include all of the information and notes required by
accounting principles generally accepted in the United States ("GAAP") for
complete financial statements and should be read in conjunction with the
Company's annual report filed on Form 10-K for the fiscal year ended September
30, 2002. In the opinion of management, all adjustments (consisting only of
adjustments of a normal and recurring nature) considered necessary for a fair
presentation of the results of operations have been included. Operating results
for the three-month period ended December 31, 2002 are not necessarily
indicative of the results that might be expected for the year ended September
30, 2003.

Revenue Recognition
Software License Fees

Revenues from software license fees consist of fees charged for the licensing of
Windows-based software products. Software license fees are recognized when
persuasive evidence of an arrangement exists, the software product has been
delivered and no significant obligations of the Company remain, the fee to the
Company is fixed and determinable, and collection of the resulting receivable is
deemed probable. Delivery occurs through the following methods:

     .    Direct Distribution: Direct revenues are recognized upon delivery to
          the end-user either via shipment of a boxed product from the Company's
          warehouse or electronic download. No returns are accepted.

     .    Retail Distribution: Retail revenues are recognized upon delivery to a
          third-party distributor, net of allowances for estimated returns.

     .    OEM: OEM revenues are generated through partnerships with hardware and
          software vendors who license the right to bundle one of the Company's
          products with the partner's products. Typically, this type of revenue
          is recognized as the partner sells through to the end-user.

     .    Consulting: Consulting revenues include fees recorded pursuant to
          long-term contracts, using the percentage of completion method of
          accounting, when significant customization or modification of a
          product is required.

     .    Consignment: Consignment revenues are recognized when a third-party
          reseller delivers the boxed product to their customer.

All desktop software products sold include free installation support and
professional software products sold include 60 days of free telephone support.
Costs associated with free support are accrued at the date of sale because the
free support is not significant. Customers that require additional post-contract
customer support ("PCS") are charged a separate fee either through a telephone
charge or annual subscription charge. Revenue and associated costs for PCS are
recognized as the services are performed or on a straight-line basis over the
contractual period.

Media Services

Revenues from services are typically recognized when persuasive evidence of a
contract exists, the service has been completed and no significant obligations
of the Company remain, the fee is fixed and determinable and collection of the
resulting receivable is deemed probable. The Company records revenue on a
percentage of completion method, generally by using the number of tapes
completed as a percentage of total tapes included in the contract, when
performing services of a duration of 30 days or more and all criteria for
recognition of service revenue are met other than completion.

                                       8

<PAGE>

We perform ongoing credit evaluations of our customers' financial condition and
generally do not require collateral. We maintain allowances for potential credit
losses and such losses have been within our expectations.

Inventories

Inventory consists of the following (in thousands):

                                             December 31,        September 30,
                                                2002                 2002
                                          -------------------------------------
Raw materials and supplies                        $  244          $  216
Work-in-process                                        4              10
Finished goods                                       176             136
                                                  ------          ------
                                                  $  424          $  362
                                                  ======          ======
Net Loss Per Share

The following table sets forth the computation of basic and diluted loss per
share:

<TABLE>
<CAPTION>
                                                                                Three months ended
                                                                                   December 31,
                                                                                2002           2001
                                                                             --------------------------
<S>                                                                         <C>          <C>
Denominator

Denominator for basic and diluted loss per share - weighted average
   common shares                                                            7,702,981    25,676,862

Securities that could potentially dilute basic earnings per share in the
 future that are not included in the computation of diluted loss per
  share as their impact is anti-dilutive:
    Options, warrants and exchangeable shares                                   5,126     2,204,194
</TABLE>

Accounting Pronouncements

In August 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets ("SFAS 144"), which addresses financial
accounting and reporting for the impairment or disposal of long-lived assets and
supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and
for Long-Lived Assets to be Disposed Of, and the accounting and reporting
provisions of APB Opinion No. 30, Reporting the Results of Operations for a
disposal of a segment of a business. FAS 144 is effective for fiscal years
beginning after December 15, 2001, with earlier application encouraged. The
Company adopted FAS 144 as of October 1, 2001. The adoption of the Statement had
no significant impact on the Company's financial position and results of
operations.

Effective October 1, 2001, the Company adopted Statement of Financial Accounting
Standards No. 142, Goodwill and Other Intangible Assets. Under SFAS No. 142,
goodwill is no longer amortized but reviewed for impairment annually, or more
frequently if certain indicators arise. The Company was required to complete the
initial step of a transitional impairment test within six months of adoption of
SFAS No. 142. During the quarter ended December 31, 2001, the Company retained
an outside valuation firm to assist in the completion of the transitional
impairment test. It was determined that the remaining goodwill of the services
reporting unit associated with the acquisitions of STV Communications, Inc. and
International Image Services, Inc. was entirely impaired, which resulted in a
$44,732,000 charge reflected as a cumulative effect of change in accounting
principle. See Note 5 for additional details.

Subsequent impairment charges for MediaSite or other acquisitions, if any, will
be reflected as an operating expense in the income statement.

                                       9

<PAGE>

2.   Liquidity and Management's Plan

In the fall of 2002, the Company determined that operations of our desktop
software and services business would not provide sufficient cash flow along with
our existing cash reserves to fund planned growth of the systems division and
make remaining subordinated debt payments. In response, the Company retained an
advisor to evaluate the sale of certain operating assets.

As of December 31, 2002, the Company had received multiple non-binding offers
from qualified bidders. Several potential buyers had been approached and
presentations regarding the businesses had occurred. At that time, no formal
offers had been made and only limited discussion regarding the value that
potential buyers placed on the various business segments had occurred.

In February 2003, the Company signed a Letter of Intent for the sale of assets
utilized in the Media Services division. The Company expects to enter into a
definitive agreement and close the transaction by the end of the second quarter
of fiscal 2003. The terms of the sale are expected to result in cash proceeds of
approximately $8.0 million including an estimate of the value of current assets
purchased less current liabilities assumed. Accordingly, the Company expects to
present Media Services as a discontinued operation in future filings.

The Company expects to enter into one or more additional definitive sale
agreements by mid 2003 regarding the sale of certain additional assets.

The Media Services transaction, if consummated, is expected to provide the
Company with sufficient resources to:
     . Retire a portion of the remaining balance due to subordinated debt
       holders
     . Support operations until another transaction can be negotiated

An additional transaction, if consummated, is expected to provide the Company
with sufficient resources to:
     . Retire the remaining balance due subordinated debt holders
     . Retire the $1,000,000 bridge note (see note 7)
     . Restructure the Company and aggressively pursue a focused strategy of
       growing the remaining business.

Management believes the proceeds of the transactions discussed above will
provide the Company with the ability to meet its cash flow obligations.
Accordingly, the financial statements have been prepared on the basis of a going
concern, which contemplates realization of assets and satisfaction of
liabilities in the normal course of business.

3.   Restructuring

As a result of rapidly changing market conditions, in December 2000 the
Company's Board of Directors authorized management to make a 40% workforce
reduction affecting all divisions of the Company in order to reduce future cash
expenditures. The restructuring charges were determined based upon plans
submitted by the Company's management and approved by the Board of Directors
using information available at the time. As a result of the workforce reduction,
the Company exited four leased facilities and disposed of fixed assets (mainly
computer equipment and trade show assets) that were no longer necessary for
future operations. Future lease obligations of facilities exited were accrued
net of estimated sub-lease income to be generated through the lease term.
Computer equipment and trade show assets no longer necessary for operations were
written down from a carrying amount of $3.1 million to their anticipated net
realizable value. As a result of the workforce reductions, termination of leases
and disposal of fixed assets, the Company recorded restructuring charges of
$3,782,000 during the first quarter of fiscal 2001. In the fourth quarter of
fiscal 2001, the Company refined the net realizable value of equipment no longer
necessary in operations that was identified in the December 2000 restructuring
plan, which resulted in an additional charge of $1,191,000. The remaining
balance of the accrual is expected to be utilized during the quarter ending
March 31, 2003 when the remaining leases expire.

<TABLE>
<CAPTION>
(in thousands)                    Severance and       Lease      Fixed asset
                                 Related Charges   Terminations   Disposals     Other   Total
                                 ---------------   ------------   ----------    -----   -----
<S>                              <C>               <C>           <C>            <C>     <C>
Charge in December 2000          $         1,470   $      1,555  $      594     $ 163   $ 3,782
</TABLE>

                                       10

<PAGE>

<TABLE>
<S>                                             <C>        <C>         <C>         <C>         <C>
Charge in September 2001                              -            -       1,191          -        1,191
                                                --------------------------------------------------------
  Total charges                                   1,470        1,555       1,785        163        4,973
Adjustments to December 2000 charge                   -         (503)        503          -            -
Amount paid in fiscal 2001, net                  (1,470)        (707)          -         (2)      (2,179)
Non-cash charges                                      -            -      (2,288)      (161)      (2,449)
                                                --------------------------------------------------------
  Accrued liabilities at September 30, 2001           -          345           -          -          345
Adjustments to December 2000 Charge                   -          (61)        121          -           60
Amount paid in fiscal 2002, net                       -         (191)          -          -         (191)
Non-cash charges                                      -            -        (121)         -         (121)
                                                --------------------------------------------------------
Accrued liabilities at September 30, 2002             -           93           -          -           93
                                                --------------------------------------------------------
Amount paid in fiscal 2003, net                       -          (86)          -          -          (86)
                                                --------------------------------------------------------
                                                $     -    $       7   $       -   $      -    $       7
                                                ========================================================
</TABLE>

4.   Acquisitions

On October 15, 2001, the Company completed the asset purchase of MediaSite,
Inc., which provided automated rich media publishing, management and access
solutions. Under terms of the purchase agreement, a wholly-owned subsidiary of
the Company purchased the majority of the assets of MediaSite and assumed
certain of its liabilities in exchange for 3,880,000 shares of the Company's
common stock and 300,000 warrants valued at $1.20 per share. Also as part of the
purchase, the Company capitalized $490,000 in closing costs, $3,101,000 in
assumed liabilities and a $365,000 advance that was issued to MediaSite in
September 2001. Approximately $9,100,000 of the purchase price was allocated to
intangible assets. The Company obtained an independent appraisal, which resulted
in an allocation of $120,000 to the Carnegie Mellon University license
agreement, $130,000 to the MediaSite trade name and $1,400,000 to acquired
technology. All three were determined to have useful lives of 5 years and will
be amortized to cost of goods sold. The remaining balance of $7,450,000 was
assigned to goodwill and, in accordance with SFAS No. 142, will not be
amortized, but will be reviewed annually for impairment.

On February 12, 2002 the Company's services division purchased all the
intellectual property rights to Media Taxi (TM) from Los Angeles based Digital
Savant, Inc. in exchange for $100,000 and 221,000 shares of the Company's common
stock. Media Taxi is a widely deployed browser-based media asset management
system focused on streamlining the management and distribution of marketing and
publicity materials for the entertainment industry. A large portion of the
acquisition price, $430,000, was assigned to goodwill and, in accordance with
SFAS No. 142, will not be amortized, but will be reviewed annually for
impairment. The remaining $240,000 was assigned to purchased technology and will
be amortized to cost of services over two years.

5.   Goodwill and Other Intangible Assets - Adoption of Statement No. 142

In July 2001, the FASB issued SFAS No. 142 Goodwill and Other Intangible Assets,
which established financial accounting and reporting for acquired goodwill and
other intangible assets and supersedes APB Opinion No. 17, Intangible Assets.
The Company early adopted SFAS No. 142 on October 1, 2001, the beginning of its
fiscal year. SFAS No. 142 requires that goodwill and intangible assets that have
indefinite useful lives not be amortized but, instead, tested at least annually
for impairment. Accordingly, the Company reclassified the net book value of
assembled workforce to goodwill and ceased amortization of all goodwill, on
October 1, 2001. Intangible assets that have finite useful lives, primarily
developed technology and know-how, continue to be amortized over their useful
lives.

The standard also requires that goodwill be tested for impairment annually. In
the year of adoption, the standard required a transitional goodwill impairment
evaluation, which was a two-step process. The first step was a screen for
whether there was an indication that goodwill was impaired as of October 1,
2001. At this time, the Company had two reporting units - software and services.
The entire goodwill balance, which had resulted from the 2000 acquisitions of
STV Communications and International Image, related to the services unit. To
determine if the goodwill was impaired, the company retained an independent
appraisal firm to perform a valuation of the services unit using the criteria
prescribed under FAS 142. As of December 2001, the appraisers completed this
first step,

                                       11

<PAGE>

which indicated that goodwill recorded during the 2000 acquisitions mentioned
above was impaired as of October 1, 2001.

For the second step, the Company used the services of the same independent
appraisal firm to compare the implied fair value of the affected reporting
unit's goodwill to its carrying value in order to measure the amount of
impairment. The fair value of goodwill was determined by allocating the
reporting unit's fair value to all of its assets and liabilities in a manner
similar to a purchase price allocation in accordance with SFAS No. 141 Business
Combinations. As of December 2001, the appraisers concluded that goodwill was
100% impaired. Therefore, the Company recorded an impairment loss of $44.7
million as a cumulative effect of a change in accounting principle in its
statement of operations.

The circumstances leading to the goodwill impairment related to: 1) the
decreased demand for digital services such as encoding (especially from dot
coms); 2) significant reductions of STV's workforce; 3) the Company's decreased
market capitalization; and 4) a history of cash flow and operating losses for
the services unit. These negative trends provided evidence that initial growth
expectations of STV and International Image did not materialize. The fair value
used to determine the impairment was based on a combination of discounted cash
flow valuation techniques, market transactions and the prices of publicly traded
comparable companies.

6.   Convertible Subordinated Debt

In January and February 2002, the Company completed a $7,125,000 offering of
convertible subordinated debt with several investors. The promissory notes
("Notes") bear interest at 10% per annum and require the Company to repay
principal (if not converted) in monthly installments commencing on August 1,
2002. The aggregate amount of such monthly installments for all the Notes is
$330,000 with a final installment in the aggregate amount of $1,181,000 due on
the maturity date of February 1, 2004.

In December 2002, the Company reached an agreement with lenders totaling $4.75
million of original principal of the Notes to modify the original repayment
terms. The terms of the agreement defer approximately $900,000 of past due and
future principal payments until the earlier of January 20, 2003 or the
completion of one of the transactions contemplated in "Liquidity and Managements
Plan", the ("Transaction"). In return, the Company agreed to provide the lenders
with a second collateral position in all the assets of the Company and to
increase the rate of interest to 12% per annum. In addition, the Company reached
an agreement with lenders of original principal totaling $1.5 million to
accelerate the date on which payment in full of the Notes would be due to the
earlier of June 1, 2003 or the completion of the Transaction.

Although the agreement reached in December 2002 with the largest of the
subordinated lenders has now expired, no action has been taken by the lenders
and no additional modifications to the note agreement have been made. The
Company anticipates using a significant portion of the proceeds from the sale of
the media services division to repay the debt.

The Notes include a covenant requiring the Company to have $2.5 million of
available cash or debt at the end of each quarter. At December 31, 2002 the
Company had total cash and available debt of slightly more than $2.5 million.

The Notes may be converted into shares of our common stock, in whole or in part,
at any time. The conversion price is $2.45 per share, subject to potential
anti-dilution adjustments. The Investors also received 1,163,000 warrants to
purchase shares of common stock at an exercise price of $2.94.

The Company also paid the placement agents $502,000 in commissions and issued
them 154,000 warrants to purchase common stock at an exercise price of $2.94.
The commissions and value of the warrants are classified as debt issuance costs
in the accompanying balance sheet.

Warrants granted to the Investors and the placement agents expire in February
2006.

The value allocated to the warrants issued was measured at the date of grant
because the number of shares was fixed and determinable. The value was
determined based upon a Black-Scholes option pricing model with the following

                                       12

<PAGE>

assumptions: risk-free interest rate of 3%, dividend yield of 0%, expected
common stock market price volatility factor of 1.5 and the expected life of the
warrants. The valuation of the investor warrants reduced the carrying value of
the debt by $2.8 million and was recorded as a debt discount. The debt discount
recorded for the warrant valuation caused a beneficial embedded conversion
feature valued at $3.5 million, which was recorded as an additional debt
discount.

The debt discount is being amortized using an effective interest method over the
two-year term of the debt. The unamortized balance of the debt discount at
December 31, 2002, was $2,273,000. The debt issuance costs are being amortized
using the straight-line method over the two-year term of the debt.

7.   Bridge Note

In November 2002 the Company completed a bridge financing transaction of
$1,000,000 with the brother of Rimas Buinevicius, Chief Executive Officer. Mr.
Buinevicius abstained from board of director discussion regarding approval of
the transaction. The note is backed by substantially all the assets of the
Company and is due, along with $250,000 of interest, at the earlier of March
2003 or upon completion of a transaction generating sufficient cash to allow for
payment. At this time, the Company does not anticipate that this note will be
paid off with proceeds of the Media Services sale.

8.   Discontinued Operations

In February 2003, the Company signed a Letter of Intent for the sale of assets
utilized in the Media Services division. The Company expects to enter into a
definitive agreement and close the transaction by the end of the second quarter
of fiscal 2003. The terms of the sale are expected to result in cash proceeds of
approximately $8.0 million including an estimate of the value of current assets
purchased less current liabilities assumed. Accordingly, the Company expects to
present Media Services as a discontinued operation in the second fiscal quarter.
The Company has not calculated the gain or loss that might result from the
transaction. As of December 31, 2002 the carrying amounts of the major classes
of assets and liabilities of the Media Services division were as follows:

                                                      December 31,
                                                          2002
                                                      ------------
           Current Assets                               $  2,668
           Fixed Assets, net                               5,603
           Other Assets                                      609

           Current Liabilities                            (1,082)
           Other Liabilities                                (193)


                                       13

<PAGE>

Item 2

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS

The following discussion of the consolidated financial position and results of
operations of the Company should be read in conjunction with the consolidated
financial statements and notes thereto included elsewhere in this form 10-Q and
the Company's annual report filed on form 10-K for the fiscal year ended
September 30, 2002. In addition to historical information, this discussion
contains forward-looking statements such as statements of the Company's
expectations, plans, objectives and beliefs. These statements use such words as
"may," "will," "expect," "anticipate," "believe," "plan," and other similar
terminology. Actual results could differ materially due to changes in the market
acceptance of our products, market introduction or product development delays,
our ability to effectively integrate acquired businesses, global and local
business conditions, legislation and governmental regulations, competition, our
ability to effectively maintain and update our product portfolio, shifts in
technology, political or economic instability in local markets, and currency and
exchange rate fluctuations.

Overview

In accordance with FAS 131 disclosure on segment reporting, the SEC's guidance
has been to present financial information in a format that is used by the
Company's management to make decisions. The Company is a leading provider of
professional rich media solutions with three primary revenue centers:

Desktop Software develops sophisticated software tools used by professionals and
hobbyists for the creation, editing and publishing of digital audio and video.
We currently focus our software efforts on the Sound Forge(R), ACID(TM), and
Vegas(R) Video platforms.

Systems Software (formerly MediaSite) develops automated rich-media applications
and scalable solutions that allow media owners - including entertainment
companies, educational institutions, corporations and government organizations -
to deploy, manage, index and distribute video content on IP-based networks.

Services supplies media digitization, management and delivery solutions for
various industries, particularly the entertainment sector. These services
consist of conversion, reformatting and encoding of television, film and other
video content for multiple delivery platforms.

These three revenue centers, along with their respective production costs, are
analyzed independently from each other. However, because the majority of
operating expenses support all revenue centers, all items below gross margin are
analyzed on a combined basis.

Critical Accounting Policies

We have identified the following as critical accounting policies to our company
and have discussed the development, selection of estimates and the disclosure
regarding them with the audit committee of the board of directors:
   .  Revenue recognition, sales returns, allowance for doubtful accounts
      and other credits;
   .  Impairment of investments and
   .  Impairment of long-lived assets.

Revenue Recognition, Sales Returns, Allowance for Doubtful Accounts and Other
Credits
We recognize revenue for licensing of software products upon shipment, net of
estimated returns, provided that collection is determined to be probable and no
significant obligations remain. Product revenue from distributors is subject to
agreements allowing limited rights of return, rebates, and price protection.
Accordingly, we reduce revenue recognized for estimated future returns, price
protection when given, and rebates at the time the related revenue is recorded
or promotion is offered. The estimates for returns are adjusted periodically
based upon historical rates of returns, inventory levels in the distribution
channel, and other related factors. The estimates and reserves for

                                       14

<PAGE>

rebates and price protection are based on historical rates. While management
believes it can make reliable estimates for these matters, nevertheless unsold
products in these distribution channels are exposed to rapid changes in consumer
preferences or technological obsolescence due to new operating environments,
product updates or competing products. Significant judgments and estimates must
be made and used in connection with establishing reserves for sales returns,
price protection and rebates in any accounting period. Material differences may
result in the amount and timing of our revenue for any period if we made
different judgments or utilized different estimates. During fiscal 2001, returns
from software products sold to consumer retail distributors were higher than
historical rates incurred in fiscal 2000 and 1999. In response to economic
factors affecting the consumer retail market, we began recording revenues to
consumer retail distributors on a consignment basis in September 2001.

Please refer to Note 1 of our Notes to Consolidated Financial Statements for
further information on our revenue recognition policies.

The preparation of our consolidated financial statements also requires us to
make estimates regarding the collectability of our accounts receivables. We
specifically analyze the age of accounts receivable and analyze historical bad
debts, customer concentrations, customer credit-worthiness and current economic
trends when evaluating the adequacy of the allowance for doubtful accounts.

Impairment of Investments

We periodically evaluate whether any estimated decline in the fair value of our
long-term investment is other-than-temporary. Significant judgments and
estimates must be made to assess the fair value of our investment and determine
whether an other-than-temporary decline in fair value of our investment has
occurred. This evaluation consists of a review of qualitative and quantitative
factors, review of publicly available information regarding the investee and
discussions with investee management. Since our investment is in a private
company with no quoted market price, we also consider the implied value from any
recent rounds of financing completed. Based upon an evaluation of the facts and
circumstances during the quarter ended June 30, 2002, we determined that our
investment had a significant decline in fair value and that we were unlikely to
recover most, if any, of our investment. Accordingly, we wrote off the entire
$514,000 balance.

Impairment of long-lived assets

We assess the impairment of goodwill on an annual basis or whenever events or
changes in circumstances indicate that the fair value of the reporting unit to
which goodwill relates is less than the carrying value. Factors we consider
important which could trigger an impairment review include the following:

..  poor economic performance relative to historical or projected future
   operating results;

..  significant negative industry, economic or company specific trends;

..  changes in the manner of our use of the assets or the plans for our business;
   and

..  loss of key personnel

If we determine that the fair value of a reporting unit is less than its
carrying value including goodwill, based upon the annual test or the existence
of one or more of the above indicators of impairment, we would then measure
impairment based on a comparison of the implied fair value of reporting unit
goodwill with the carrying amount of goodwill. The implied fair value of
goodwill is determined by allocating the fair value of a reporting unit to its
assets (recognized and unrecognized) and liabilities in a manner similar to a
purchase price allocation. The residual fair value after this allocation is the
implied fair value of reporting unit goodwill. To the extent the carrying amount
of reporting unit goodwill is greater than the implied fair value of reporting
unit goodwill, we would record an impairment charge for the difference.

The Company evaluates all of its long-lived assets, including intangible assets
other than goodwill, for impairment in accordance with the provisions of SFAS
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS
144 requires that long-lived assets and intangible assets other than goodwill be
evaluated for

                                       15

<PAGE>

impairment whenever events or changes in circumstances indicate that the
carrying value of an asset may not be recoverable based on expected undiscounted
cash flows attributable to that asset. Should events indicate that any of the
Company's assets are impaired; the amount of such impairment will be measured as
the difference between the carrying value and the fair value of the impaired
asset and recorded in earnings during the period of such impairment.

Results of Operations

The following chart has been presented to add clarification and should be read
in conjunction with the consolidated financial statements.

<TABLE>
<CAPTION>
                                                          Three months ended December 31,
                                                              2002                2001
                                                      -------------------------------------
<S>                                                  <C>          <C>     <C>         <C>
  Desktop software license fees                       $  3,948     100%    $ 3,553     100%
  Cost of desktop software license fees                    674      17         963      27
                                                      ------------------------------------
   Gross margin-desktop software license fees         $  3,274      83%    $ 2,590      73%

  Systems software license fees                       $    173     100%    $   138     100%
  Cost of systems software license fees                    157      91          36      26
                                                      ------------------------------------
    Gross margin-systems software license fees        $     16       9%    $   102      74%

  Services                                            $  1,911     100%    $ 2,347     100%
  Cost of services                                       1,651      86       1,777      76
                                                      ------------------------------------
    Gross margin-services                             $    260      14%    $   570      24%
</TABLE>

Revenue from Software License Fees

Software license fees in the Statement of Operations includes both desktop and
systems software.

Revenues from desktop software license fees consist of fees charged for the
licensing of Windows based software products. The Company's primary focus is on
the platforms of ACID(R), Sound Forge(R), CD Architect(R) and Vegas(R) Video.
These software products are marketed to both consumers and producers of digital
media. We reach both our domestic and international markets through traditional
retail distribution channels, our direct sales effort and OEM partnerships.

Q1-2003 compared to Q1-2002

Net revenues from desktop software license fees increased $395 or 11% from
Q1-2002 to Q1-2003. The net changes resulted from the following items:

     .   $402 of the increase resulted from sales of CD Architect. CD Architect
         development was discontinued in December 2000 and the product had no
         sales in Q1-2002. In late 2002, we put additional development effort
         into the product and released a new version in Q1-2003.
     .   $148 of the increase resulted from sales of Sound Forge and Sound
         Forge based bundles. Version 6 of Sound Forge was released in May 2002
         and continues to experience steady sales. For Q1-2003 and Q1-2002,
         Sound Forge products accounted for just under 30% and just under 20%,
         respectively, of Desktop Software sales.
     .   ACID and ACID Loop sales increased $65. Q1-2003 benefited from the
         August 2002 release of version 4.0. Sales of ACID and ACID LOOPS were
         just under 30% of Desktop Software sales in both periods.
     .   Vegas Video declined slightly ($71) from quarter to quarter. The
         Q1-2002 release of Vegas Video 3.0 drove sales to nearly $600. Q1-2003
         sales were negatively impacted by anticipation of the Vegas 4.0
         release in February 2003. For Q1-2003 and Q1-2002, Vegas Video
         accounted for 13% and 16% of Desktop Software sales. We believe sales
         of Vegas 4.0 and its complimentary DVD architect product could
         approach 50% of Desktop Software sales in Q2-2003.

                                       16

<PAGE>

Gross Margin from Software License Fees

Costs of software in the Statement of Operations includes both desktop and
systems software.

Included in costs of desktop software license fees are product material costs,
assembly labor, freight, royalties on third party technology or intellectual
content, and amortization of previously capitalized product development and
localization costs. Q1-2003 software gross margin dollars increased over
Q1-2002. The improved margins on a percentage basis can be attributed to:
  .  A reduction in material costs associated with an increase in the number of
     electronic downloads (in Q1-2003, 25% of sales were electronic downloads
     vs. 23% in Q1-2002).
  .  Reduced obsolescence and scrap due to lower inventory levels.
  .  Q1-2002 margins were negatively impacted by a one-time write-off of MPEG
     licenses as a result of a contract termination.

Revenue from Systems Software

Revenue from our Systems software division, established upon the acquisition of
MediaSite, consist of fees charged for the licensing of software products and
custom software development. The primary focus is on the MediaSite Live(TM)
platform released in June 2002. In addition, the division markets MediaSite
Publisher(TM) and custom development solutions. Both products and the custom
development efforts are marketed to government agencies, educational
institutions, and corporations who need to deploy, manage, index and distribute
video content on IP-based networks. We reach both our domestic and international
markets through reseller networks, a direct sales effort and Integrator
partnerships.

System software revenues in Q1-2003 amounted to $173; Q1-2002 sales were $138.
The revenues can be segmented as follows:
  .  MediaSite Live, accounted for all sales in Q1-2003.
  .  MediaSite Publisher sales were $16 for Q1-2002.
  .  Custom development for a Federal agency accounted for $121 of revenue in
     Q1-2003. This contract was completed in May 2002.

Gross Margin from Systems Software

The significant components of cost of systems include:
  .  Cost of hardware that is bundled with MediaSite Live. Live sales should
     typically result in gross margins of approximately 60%.
  .  Amortization of MediaSite acquisition amounts assigned to purchased
     technology and other identified intangibles. We will be amortizing
     approximately $100 per quarter over the next 4 years for the identified
     intangibles of the MediaSite purchase.

Revenue from Services

Revenue from services includes tape duplication for broadcast distribution,
broadcast standard conversions, audio and video encoding, as well as fees for
consulting and development services.

Revenue from services declined $436 or 19%, from Q1-2002 to Q1-2003. Sales for
the operations in Toronto and Los Angeles declined by approximately $200 in each
location. Revenues from smaller customers were impacted to a greater extent in
both locations than that of our largest customers and appear to be a result of a
decline in their advertising revenue.
Our traditional duplication and conversion services accounted for all of the
quarter to quarter decline. This decline was partially offset by growth in our
digital restoration, digital conversion, encoding and High Definition services
(grew from approximately $250 to approximately $300) and revenues from
consulting and the MediaTaxi technology, acquired from Digital Savant in
February 2002, ($20) during Q1-2003.

                                       17

<PAGE>

Gross Margin from Services

Costs of services include compensation, benefits and other expenses associated
with production personnel, videotape costs, depreciation on production equipment
and an allocation for general and administrative expenses such as facility
costs. These costs have become relatively stable and fixed in dollars since
Q3-2001.

Gross Margin from services declined from 24% to 14% from Q1-2002 to Q1-2003. The
decline relates to the revenue decreases discussed above and demonstrates the
fixed nature of our cost of services. The headcount of production staff in Media
Services declined from 69 in Q1-2002 to 57 in Q1-2003. However, those savings
were offset slightly by $30 of amortization for the MediaTaxi technology
acquired in February 2002.

Operating Expenses

The following chart is provided to add clarification by presenting items as a
percentage of total revenues. For comparison purposes, amortization of goodwill
has been excluded from the 2001 results due to the adoption of SFAS No. 142.
Please see Note 1 of the financial statements for further details. This should
be read in conjunction with the unaudited consolidated financial statements
presented in this filing.

                                                       Three months ended
                                                          December 31,
                                                      2002          2001
                                                   -------------------------
Total revenues                                           100%          100%
Cost of revenues                                          41            46
                                                   -------------------------
  Gross margin                                            59            54

Operating expenses
  Selling and marketing expenses                          39            40
  General and administrative expenses                     28            27
  Product development expenses                            27            30
                                                   -------------------------
     Total operating expenses                             94            97
                                                   -------------------------
     Loss from operations                                (35)%         (43)%
                                                   =========================

Selling and Marketing Expenses

Selling and marketing expenses include: wages and commissions for sales,
marketing, business development and technical support personnel; our direct mail
catalog; and co-operative advertising with our software distributors, print
advertising and various promotional expenses for our products, services and
systems. Timing of these costs may vary greatly depending on introduction of new
offerings and entrance into new markets.

                           Q1-2003 compared to Q1-2002

Selling and marketing expenses as a percentage of revenues and in gross dollars
remained relatively flat for the quarter period, although the mix across
divisions varied significantly.

A slight $30 or 1% decrease from Q1-2002 to Q1-2003 is attributable to a decline
in catalog, advertising and other spending that was partially offset by
increases in strategy and systems sales and marketing. Expenditures for the
direct catalog campaign decreased $350 from quarter-to-quarter. Q1-2002 mailings
promoted the launch of Vegas Video 3.0. Q1-2003 included a lower level of
mailings to launch CD Architect. Over the past year we have built a larger
database of names and no longer have to rent expensive lists for our catalog
campaigns. Also, much of the direct advertising has switched to email. Coop and
other advertising declined $120 from quarter-to-quarter. Due to the nature of
the 1Q-2003 MDF activity, $190 was recorded as a direct reduction of revenue
rather than sales expense.

                                       18

<PAGE>

The above items were offset by increases in the new systems software and
business development divisions. The addition of these divisions added nearly 20
people. Expenditures - primarily salaries, severance accruals, travel and public
relations - amounted to over $900 in the current quarter, which was an increase
of $540 from Q1-2002. The severance amounts - resulting primarily from the
elimination of executive level positions in the systems division -amounted to
just over $300.

Direct sales and marketing expenses for Media Services, all of which will be
eliminated upon sale of the Media services division, amounted to $273 in
Q1-2003.

General and Administrative Expenses

General and administrative ("G&A") expenses consist of personnel and related
costs associated with the facilities, finance, legal, human resource and
information technology departments, as well as other expenses not fully
allocated to functional areas.

                           Q1-2003 compared to Q1-2002

G&A expenses increased by $100 or 6%, from Q1-2002 to Q1-2003. The increase is
the result of a $240 increase in legal fees, which reflects various defense
costs and general corporate activity regarding the sale of business units,
partially offset by lower consulting fees, property taxes and bad debt expense.

Direct general and administrative expenses for Media Services, all of which will
be eliminated upon sale of the Media services division, amounted to $200 in
Q1-2003. We also expect reductions in indirect expenses, related to services
provided by corporate staff and facilities, as a result of the pending Media
Services transaction.

Product Development Expenses

Product development expenses include salaries and wages of the software research
and development staff and an allocation of benefits, facility and administrative
expenses. Fluctuations in product development expenses correlate directly to
changes in headcount.

Q1-2003 compared to Q1-2002

Product development expenses declined $286 or 15% from Q1-2002 to Q1-2003. End
of quarter head count decreased from 67 to 60 due to attrition and workforce
reductions in the Systems division.

In accordance with SFAS Number 86, the Company capitalizes the cost of
development of software products that have reached technological feasibility and
then amortizes that cost over the anticipated life of the product. No
development costs for our core product line were capitalized during fiscal 2002
or the first quarter of 2003. Amortization of capitalized software development
was $55 in Q1-2002 and relates to Viscosity(TM), which was a result of the Jedor
acquisition in February 2000. Viscosity was fully amortized in January 2002.

Going forward we do not anticipate that any fiscal 2002 software development
efforts will qualify for capitalization under SFAS Number 86.

Direct Product development expenses for Media Services, all of which will be
eliminated upon sale of the Media services division, amounted to $80 in Q1-2003.

Other Income (Expense)

The increase in interest expense was due to the subordinated debt issuance in
February 2002. (see Note 6 to the consolidated financial statements). In
addition, in Q1-2003 we recorded $100 of interest expense related to the Bridge
note (see note 7 to the consolidated financial statements).

                                       19

<PAGE>

Income taxes

Q1-2003 losses for the Canadian services division and its Canadian parent
resulted in $88 of income tax benefit for the quarter.

Cumulative Effect of Changes in Accounting Principle

Effective October 2001, the Company adopted Financial Accounting Standards Board
("SFAS") No. 142, "Goodwill and Other Intangible Assets." Under the new rules,
the Company ceased the amortization of goodwill associated with the services
reporting unit, which included the acquisitions of STV Communications and
International Image. Implementation of the new rules also requires an assessment
of the carrying value of goodwill using a number of criteria, including the
value of the overall enterprise as of October 1, 2001. The Company retained an
independent appraisal firm to assist in the assessment, which resulted in a
$44,732 write off of the entire remaining value of goodwill associated with the
services reporting unit. Future impairment charges, if any, associated with
MediaSite or other acquisitions will be reflected as an operating expense in the
statement of operations.

Liquidity and Capital Resources

Cash used in operating activities was $1,573 for Q1-2003 compared to $1,836 in
Q1-2002. Operations for the two quarters were similar, but Q1-2002 had greater
outflows related to AP assumed in the MediaSite transaction and Q1-2003 had
improved company wide Days Sales Outstanding of 59 days (compared to 64 days in
Q1-2002).

Cash used in investing activities was $18 in Q1-2003 compared to $606 in
Q1-2002. The investing activities in the prior year included $435 for the
MediaSite acquisition. In addition, due to our current financial status, capital
expenditures were limited in the current quarter. No significant investing
activity is expected for either the Desktop software or Systems divisions in the
near future.

Cash provided by financing activities was $182 in Q1-2003 compared to cash used
of $1,232 in Q1-2002. In Q1-2003 we completed a bridge financing transaction of
$1,000,000 with the brother of Rimas Buinevicius, Chief Executive Officer. We
also incurred an additional $69 of debt under the employee deferred compensation
plan. The salary deferral and resulting increases to debt concluded in December.
The notes under the deferred compensation plan begin to mature in January 2004.
During Q1-2003 we also paid $87 of the line of credit of our Canadian
operations. In Q1-2002, we deposited $1,000 with the Ontario Superior Court of
Justice to be held in trust until settlement of a lawsuit with the former
shareholders of International Image. We settled with those former shareholders
in summer and fall of 2002 and the deposit was returned.

During Q1-2003 the company also paid the required quarterly interest payments
($176) to the subordinated debt holders.

Recent Developments Impacting Liquidity

In December 2002, the Company reached an agreement with lenders totaling $4.75
million of original principal of the Notes to modify the original repayment
terms. The terms of the agreement defer approximately $900,000 of past due and
future principal payments until the earlier of January 20, 2003 or the
completion of one of the transactions contemplated in "Liquidity and Managements
Plan", the ("Transaction"). In return, the Company agreed to provide the lenders
with a second collateral position in all the assets of the Company and to
increase the rate of interest to 12% per annum. In addition, the Company reached
an agreement with lenders of original principal totaling $1.5 million to
accelerate the date on which payment in full of the Notes would be due to the
earlier of June 1, 2003 or the completion of the Transaction.

Although the agreement reached in December 2002 with the largest of the
subordinated lenders has now expired, no action has been taken by the lenders
and no additional modifications to the note agreement have been made. The
Company anticipates using a significant portion of the proceeds from the sale of
the services division to repay the debt.

In February 2003 we signed a Letter of Intent for the sale of assets utilized
in the Media Services

                                       20

<PAGE>

division. We expect to enter into a definitive agreement and close the
transaction by the end of the second quarter of fiscal 2003. The terms of the
sale are expected to result in cash proceeds of approximately $8.0 million
including an estimate of the value of current assets purchased less current
liabilities assumed.

The Company expects to enter into one or more additional definitive sale
agreements by mid 2003 regarding the sale of certain additional assets.

On January 2, 2003 we repaid the Canadian line of credit balance of $367 and
have since agreed to terminate the agreement.

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Derivative Financial Instruments

The Company is not party to any derivative financial instruments or other
financial instruments for which the fair value disclosure would be required
under SFAS No. 107, Derivative Financial Instruments, Other Financial
Instruments and Derivative Commodity Instruments. The Company's cash equivalents
consist of overnight investments in money market funds that are carried at fair
value. Accordingly, we believe that the market risk of such investments is
minimal.

Interest Rate Risk

The Company's cash equivalents are subject to interest rate fluctuations,
however, we believe this risk is immaterial due to the short-term nature of
these investments.

Foreign Currency Exchange Rate Risk

All international sales of our software products are denominated in US dollars.
However, the majority of transactions for our services division in Toronto are
denominated in Canadian dollars. Although these transactions are not generally
subject to significant foreign exchange rate gains and losses, they are
translated into US dollars as part of our consolidated financial statements and
therefore fluctuations in the exchange rate will affect our consolidated
financial statements. The Canadian dollar has been stable relative to the US
dollar and we have not engaged in any foreign currency hedging activities.

Item 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Based on evaluations as of a date within 90 days of the filing date of this
report, our principal executive officer and principal financial officer, with
the participation of our management team, have concluded that our disclosure
controls and procedures (as defined in Rules 13a-14 (c) and 15d-14 (c) under the
Securities Exchange Act) are effective to ensure that information required to be
disclosed by us in reports that we file or submit under the Securities Exchange
Act is recorded, processed, summarized and reported within the time periods
specified in the rules and forms of the SEC.

Changes in Internal Controls

There were no significant changes in our internal controls or in other factors
that could significantly affect these internal controls subsequent to the date
of their most recent evaluation, including any corrective actions with regard to
significant deficiencies and material weaknesses.

                                       21

<PAGE>

                            PART II OTHER INFORMATION

Item 3. DEFAULTS UPON SENIOR SECURITIES

In December 2002, the Company reached an agreement with lenders totaling $4.75
million of original principal of the subordinated notes to modify the original
repayment terms. The terms of the agreement defer approximately $900,000 of past
due and future principal payments until the earlier of January 20, 2003 or the
completion of one of the transactions contemplated in "Liquidity and Managements
Plan", the ("Transaction"). In return, the Company agreed to provide the lenders
with a second collateral position in all the assets of the Company and to
increase the rate of interest to 12% per annum. Although the agreement reached
in December 2002 has now expired, no action has been taken by the lenders and no
additional modifications to the note agreement have been made. The Company
anticipates using a significant portion of the proceeds from the anticipated
sale of the services division to repay the debt.

Item 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits (see exhibit list)

(b) Reports on Form 8-K
    None

ITEM 6(a)

NUMBER                                DESCRIPTION
------  ------------------------------------------------------------------------

2.1        Amendment No. 1 to the Purchase Agreement dated February 11, 2002 by
           and between Sonic Foundry, Inc. and Omicron Partners, L.P, filed as
           exhibit 2.1 to the registration statement on Form S-3 filed on April
           29, 2002, and hereby incorporated by reference.

2.2        Note - Exhibit A to Amendment No. 1 to the Purchase Agreement, filed
           as exhibit 2.2 to the registration statement on Form S-3 filed on
           April 29, 2002, and hereby incorporated by reference.

2.3        Warrant - Exhibit B to Amendment No. 1 to the Purchase Agreement,
           filed as exhibit 2.3 to the registration statement on Form S-3 filed
           on April 29, 2002, and hereby incorporated by reference.

2.4        Registration Rights Agreement - Exhibit C to Amendment No. 1 to the
           Purchase Agreement, filed as exhibit 2.4 to the registration
           statement on Form S-3 filed on April 29, 2002, and hereby
           incorporated by reference.

3.1        Amended and Restated Articles of Incorporation of the Registrant,
           filed as Exhibit No. 3.1 to the registration statement on amendment
           No. 2 to Form SB-2 dated April 3, 1998 (Reg. No. 333-46005) (the
           "Registration Statement"), and hereby incorporated by reference.

3.2        Amended and Restated By-Laws of the Registrant, filed as Exhibit No.
           3.2 to the Registration Statement, and hereby incorporated by
           reference.

10.1*      Registrant's 1995 Stock Option Plan, as amended, filed as Exhibit No.
           4.1 to the Registration Statement on Form S-8 on September 8, 2000,
           and hereby incorporated by reference.

10.2*      Registrant's Non-Employee Directors' Stock Option Plan, filed as
           Exhibit No. 10.2 to the Registration Statement, and hereby
           incorporated by reference.

10.3*      Employment Agreement between Registrant and Rimas Buinevicius dated
           as of January 1, 2001, filed as Exhibit 10.4 to the Quarterly Report
           on Form 10-Q for the quarter ended March

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<PAGE>

            31, 2001, and hereby incorporated by reference.

10.4*       Employment Agreement between Registrant and Monty R. Schmidt dated
            as of January 1, 2001, filed as Exhibit 10.5 to the Quarterly Report
            on Form 10-Q for the quarter ended March 31, 2001, and hereby
            incorporated by reference.

10.5*       Employment Agreement between Registrant and Curtis J. Palmer dated
            as of January 1, 2001, filed as Exhibit 10.6 to the Quarterly Report
            on Form 10-Q for the quarter ended March 31, 2001, and hereby
            incorporated by reference.

10.6        Digital Audio System License Agreement between Registrant and Dolby
            Laboratories Licensing Corporation dated July 28, 1997, filed as
            Exhibit No. 10.7 to the Registration Statement, and hereby
            incorporated by reference.

10.7        Digital Audio System License Agreement between Registrant and Dolby
            Laboratories Licensing Corporation dated July 28, 1997, filed as
            Exhibit No. 10.8 to the Registration Statement, and hereby
            incorporated by reference.

10.9        Convertible Debenture Purchase Agreement dated September 13, 1999
            between Purchasers and the Registrant filed as Exhibit No. 10.17 to
            the Current Report on form 8-K filed on September 24, 1999, and
            hereby incorporated by reference.

10.10       Commercial Lease between Registrant and Tenney Place Development,
            LLC regarding 1617 Sherman Ave., Madison, Wisconsin dated October 1,
            1999, filed as Exhibit No. 10.18 to the Annual Report on form 10-K
            for the period ended September 30, 1999, and hereby incorporated by
            reference.

10.11       Commercial Lease between Registrant and Hargol Management Limited
            regarding 23 Prince Andrew Place, Don Mills, Ontario, Canada dated
            January 15, 1990, filed as Exhibit No. 10.20 to the Amended Annual
            Report on Form 10-K/A for the year ended September 30, 2000, and
            hereby incorporated by reference.

10.12       Commercial Lease between Registrant and the Richlar Partnership
            regarding 1703 Stewart St., Santa Monica, CA, dated August 10, 1995,
            filed as Exhibit No. 10.21 to the Amended Annual Report on Form
            10-K/A for the year ended September 30, 2000, and hereby
            incorporated by reference.

10.13       Commercial Lease between Registrant and Thomas Seaman regarding
            12233 Olympic Blvd., Santa Monica, CA, dated January 23, 2000 filed
            as Exhibit No. 10.22 to the Amended Annual Report on Form 10-K/A for
            the year ended September 30, 2000, and hereby incorporated by
            reference.

10.14       Registration Rights Agreement, dated March 31, 2000, among the
            Company and Sony Pictures Entertainment Inc., filed as Exhibit 4.6
            to the Registration Statement filed on Form S-3 on May 12, 2000, and
            hereby incorporated by reference.

10.15       Buyer Non-Voting Exchangeable Share Option Agreement, dated August
            24, 2000, among the Registrant, Dan McLellan, Curtis Staples, and
            Sonic Foundry (Nova Scotia), Inc., filed as Exhibit 4.3 to the
            Registration Statement filed on Form S-3 on November 7, 2000, and
            hereby incorporated by reference.

10.16       Support Agreement, dated August 24, 2000, between the Company and
            Sonic Foundry (Nova Scotia), Inc. filed as Exhibit 4.4 to the
            Registration Statement filed on Form S-3 on November 7, 2000 and
            hereby incorporated by reference.

10.17       Commercial Lease between Ewart Associates, L.P. and Sonic Foundry
            Systems Group, Inc.

                                       23

<PAGE>

            (now known as Sonic Foundry Media Systems, Inc.), regarding 925
            Liberty Avenue, Pittsburgh, PA 15222, dated November 30, 2001, filed
            as Exhibit No. 10.23 to the Quarterly Report on Form 10-Q for the
            quarter ended March 31, 2002, and hereby incorporated by reference.

10.18       Commercial Lease between Stonewood East and Sonic Foundry Media
            Systems, Inc. regarding 12300 Perry Highway, Wexford, PA, dated
            January 13, 2002 filed as Exhibit No. 10.24 to the Quarterly Report
            on Form 10-Q for the quarter ended March 31, 2002, and hereby
            incorporated by reference.

10.19       Asset Purchase Agreement and Plan of Asset Transfer and
            Reorganization dated September 6, 2001 by and among Sonic Foundry,
            Inc., Sonic Foundry Systems Group, Inc. (formerly known as MediaSite
            Acquisition, Inc.), and MediaSite, Inc., filed as Exhibit No. 2.1 to
            the Current Report on Form 8-K dated October 30, 2001, and hereby
            incorporated by reference.

10.20       Asset Purchase Agreement dated February 6, 2002 by and among Sonic
            Foundry Media Services, Inc. and Digital Savant, Inc, filed as
            Exhibit No. 10.26 to the Quarterly Report on Form 10-Q for the
            quarter ended March 31, 2002, and hereby incorporated by reference.

10.21*      Registrant's 2001 Deferred Compensation Plan, filed as Exhibit 4.4
            to Form S-8 on November 21, 2001 and hereby incorporated by
            reference.

10.22       Stock Restriction and Registration Agreement between Sonic Foundry,
            Inc., Zero Stage Capital VI Limited Partnership, Saturn Capital,
            Inc. and Saturn Partners Limited Partnership dated October 15, 2001
            filed as Exhibit 4.4 to Form S-3 filed on December 21, 2001, and
            hereby incorporated by reference.

10.23*      Registrant's Amended 1999 Non-Qualified Plan, filed as Exhibit 4.1
            to Form S-8 on December 21, 2001, and hereby incorporated by
            reference.

10.24       Software License and Marketing Agreement effective as of March 25,
            2002 between Registrant and Broderbund Properties LLC filed as
            Exhibit No. 99.2 to the Registration Statement on Form S-3 filed on
            August 13, 2002 and hereby incorporated by reference.

10.25       Amended and Restated License Agreement effective October 15, 2001
            between Carnegie Mellon University and MediaSite, Inc. filed as
            Exhibit No. 10.31 to the Quarterly Report on Form 10-Q for the
            quarter ended March 31, 2002 , and hereby incorporated by reference.

10.26       Warrant Agreement filed as Exhibit 10.1 to Registration Statement
            No. 333-98795 on Form S-3 filed on August 27, 2002 and hereby
            incorporated by reference.

10.27       Promissory Note between Registrant and Aris A. Buinevicius and
            Claire Horne for $1,250,000 dated November 18, 2002.

99.1        Section 906 Certification of Chief Executive Officer

99.2        Section 906 Certification of Chief Financial Officer

            *Compensatory Plan or Arrangement

                                       24

<PAGE>

SIGNATURES

Pursuant to the requirement of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

                               Sonic Foundry, Inc.
                               -------------------
                                  (Registrant)

February 14, 2003              By:  /s/ Rimas P. Buinevicius
                                    ------------------------
                                    Rimas P. Buinevicius
                                    Chairman and Chief Executive Officer

February 14, 2003              By:  /s/ Kenneth A. Minor
                                    --------------------
                                    Kenneth A. Minor
                                    Chief Financial Officer and Secretary

                                       25